Investment Outlook 09.2016
Thomas TrauthEconomist, Dr. rer. pol., CFA, FRM
What to expect from central banks?
In July and August risky assets rallied strongly. Emerging markets outperformed developed markets. In particular, the Brazilian Bovespa index rose by 11.2% in July and 1.0% in August. This lifted the year-to-date performance of the Brazilian stock market to a remarkable 32%. Among developed markets, the European and the Japanese stock markets outperformed. In July and August the EuroStoxx50 gained about 5.5% and the Nikkei225 more than 8%.
UK equity markets also rebounded, supported by the weaker GBP. The FTSE100 gained about 4% and the more local FTSE250 even 9% in July and August combined.
During July and August so-called safe-haven assets lost value. For example, 10-year government bond yields rose in Europe by 6 bps and in the US by 11 bps. While the short end of the EUR yield curve remained firmly anchored, US 2-year yields rose by 22 bps, discounting a higher probability of a Fed rate hike.
Inflation expectations, as measured by 10-year break-even inflation rates, rose only slightly. Credit spreads tightened further in July and August.
The price for Brent oil has been fluctuating between 40 and 50 USD/bl. The Gold price has remained in a trading range between 1,310 and1,370 USD/oz.
The strong rally in global REITS, which gained 22% between Mid-February and end of July, came to an end. Since late July REITS have suffered from rising yields and, in addition, from declining stock markets since early September.
The GBP remained on the weak side. It has been fluctuating around 1.30 to the USD since end of June. The Chinese CNY has currently remained range-bound around 6.65 to the USD. The JPY – after its pronounced rally from November 2015 on – has stabilized at around 102 to the USD. The Swiss Franc gave back some of its gains after the Brexit vote and is currently trading around 1.09 to the EUR.
The positive market environment suddenly came to an end after ECB’s policy meeting on 8 September. While policy measures remained unchanged, Draghi’s announced intention to redesign the quantitative easing (QE) program sparked fears among market participants that the QE program could end earlier than expected.
This led to a pronounced sell-off of bonds and equity markets, which has hit multi-asset class investors badly.
Global growth indicators disappointed in August. Especially US growth indicators were weak. The US ISM manufacturing index fell markedly to 49.4 in August from 52.6. Also US non-farm payrolls rose by only 151,000 in August after 275,000 in July. Looking at the monthly average, however, the US economy is still adding jobs at a healthy pace.
The European manufacturing PMI weakened only slightly and fell to 51.7 in August after 52.0.
Overall, inflation remained at very low levels. If, however, oil prices remain at current levels, we will see an uptick of headline inflation in early 2017. This is the result of base effects, since energy prices are likely to exceed their very low levels in early 2016.
At its 8 September meeting the ECB left rates and its quantitative easing program unchanged. However, President Draghi announced that the ECB is considering a redesign of its quantitative easing (QE) program. While this sparked fears that the ECB may end its QE program sooner than expected, we think that such fears are exaggerated or at least premature. We, instead, think that the ECB is contemplating measures to overcome some shortcomings in its QE program and ways of making it more effective. The ECB may, for example, decide to abandon its self-imposed limit of not buying more than one-third of a bond issue, which has proved to be a severe limitation.
Our view is supported by the fact that the ECB lowered its growth and inflation forecasts, albeit only marginally, and that Draghi said the ECB will continue its QE program until or beyond the current expiry date, and that it will run until the inflation path returns to the desired level. Inflation is currently much lower than the ECB’s definition of price stability, which is below, but close to, 2%.
The Swiss National Bank (SNB) held its policy meeting on 15 September. The SNB did not change its policy stance but reiterated that it will intervene in currency markets if needed. The deposit rate currently stands at minus 0.75%. This is hurting banks and insurance companies. The SNB acknowledged this but is more worried about the over-valued Swiss franc, which is hurting the whole economy.
Following the recent ECB and SNB meetings, very important meetings will be held by the US Fed and the Bank of Japan (BoJ) on 21 September.
At its on its 20-21 September meeting the Fed will decide on the future path of rates. It is unlikely in our view that they will raise rates or turn very hawkish. Recent growth data have been disappointing. However, they may face a dilemma with regard to the US elections in November. A hike in December, which is expected by many, could be seen as negative for the newly elected president. As a result, the Fed may fear falling too far behind the curve and may raise rates as early as September. This could have a negative effect on markets for risky assets, though we think such an effect would prove to be temporary. Currently the market is pricing a probability of 20% for a rate hike in September and 55% for December.
The BoJ will also meet on 21 September. There is much speculation on whether the BoJ will take additional QE measures, like buying foreign bonds instead of only domestic bonds or introducing a new core inflation target of 1.5%. Overall, we consider it likely that additional stimulus measures will be decided. Otherwise, the JPY may appreciate further and possibly break below 100 to the USD.
The market reaction to ECB’s September meeting is a reminder that market sentiment remains fragile. Draghi’s comments may have recalled the so-called “tapper tantrum”. On 22 May 2013, in a testimony before Congress, Mr. Bernanke announced the Fed’s intention to lower its monthly bond purchases, which led immediately to a pronounced sell-off of bond and equity markets globally. While US rates continued to grind higher until year-end, the equity sell-off was short-lived and reversed, especially since macro data were very robust in the following months. The actual tapering only started on 18 December 2013, when the Fed reduced its bond purchases by USD 10 bn per month.
We think that taper fears with regard to the ECB are greatly exaggerated and premature. As discussed above, the redesign of the QE program will more likely lead to an expansion of QE.
The Fed and BoJ meetings on 21 September will provide further indications about the future path of monetary policy. We expect both central banks to be rather dovish, although there is a certain chance that the Fed could take the opportunity to hike before the elections in November.
We remain cautiously positioned and continue to like the risky part of the bond market (high-yield and emerging markets). Our equity positioning remains neutral with an overweight of European and Asian equity markets. We continue to see commodities range-bound, the USD stronger and the CHF weaker.